When the market ‘bobs along the top,’ it’s time to scratch beneath the surface

This week, about 700 private real estate executives spanning the sector’s investor, manager and advisor spectrums descended on Hong Kong’s Grand Hyatt hotel for four unadulterated days of presentations, declarations and warnings from PERE’s nominated roster of speakers. But it was the warnings that sounded the loudest.

There was a common thread among the warnings heard by delegates over PERE Asia week: investors scratching beneath the surface of the strategies they are backing today might find things they do not like.

Real estate debt fund investors were warned to consider the potential pitfalls of backing strategies run by real estate equity-minded managers. ‘Loan-to-own’ strategies are not supposed to be prevalent among this proliferating alternative to core funds. But check the backgrounds of who is running the fund, forewarned Sonny Kalsi, co-founder of private equity real estate firm GreenOak Real Estate, which runs senior lending strategies from its Europe division with a decidedly credit-orientated management team. “Equity guys always believe the glass is half-full. That’s a bad way to be a lender,” he warned, adding lending with the belief you will be handed keys after a default has to be misguided.

Hotel fund investors came under the spotlight, too, as did any investors backing operationally-intensive property. As with debt investors, if generalist managers are placing these kinds of assets into their mixed portfolios, then they had better understand what to do with them in the event of operators failing in their own strategies. In this case, the warning was that finding replacement hoteliers when the team does not have a specialization in hotels is indeed a mean feat.

Where that leaves private real estate after the ‘hotelization’ trend – also widely discussed at the event – takes firm hold across every property type is anyone’s guess, then. Although perhaps we are some way off from needing to take the term literally. Landlords becoming service providers and tenants becoming customers is a real thing, but replacing the coffee shop or exercise studio from the mezzanine level of a 20-story office property is a far cry from a wholesale switch in hotel operation.

Another warning came from the most obvious place: leverage at the deal level. This was the first PERE Asia since the global financial crisis where a speaker shouted ‘shark’ in the form of 90 percent loan-to-values – as did BPE Asia’s real estate head Mark Fogle, who claimed to have seen such leverage levels materialize in Asia’s cheapest debt markets. On the surface, managers have largely kept to their mantras of keeping debt capped at the 60 percent mark for opportunistic strategies. But scratch away at it, and additional mezzanine or even subscription financing has allegedly brought up those levels to toxic pre-crisis levels. Fund level financing oftentimes is unreported as credit owing to its typical short span use of between one and two quarters.

Such masquerading is, of course, worrying. But the biggest area of concern among PERE Asia’s warning signs surely came in the picture Fogle painted of core and opportunistic managers underwriting business plans for the same buildings in exactly the same way – the only difference in strategy being the amount of credit borrowed to buy it. It should not take much scratching by investors to realize which managers can demonstrate actual expertise in the strategies they promote and those which are still counting on a type of beta as the market “bobs along the top” – the variable cost of debt – to get deals done. As Fogle said: “If you look at a deal and the way to do it is with high leverage, is it really real estate?”